prudential regulation and supervision of the banking ...€¦ · prudential regulation and...

BDDK Bankac›l›k ve Finansal PiyasalarCilt: 1, Say›: 2, 2007

Prudential Regulation and Supervision ofthe Banking Sector and Banking Crises:A Cross Country Empiricial Investigation

Prudential Regulation and Supervision ofthe Banking Sector and Banking Crises:A Cross Country Empiricial Investigation

Aytül Ganio¤lu*

Abstract

The main purpose in this study is to see empirically whether there really exists a cle-ar association between weaknesses in the regulation and supervision of the bankingsector and banking crises. Test results indicate that capital regulations are a major fac-tor in the prevention of crises, giving important support to the propositions towardsensuring higher capital requirements. However, tighter capital regulations do not se-em to mitigate the negative impact of moral hazard problem generated by generousdeposit insurance system. While inflation has a significant role in the generation of cri-sis, its significance weakens to a major extent, when accompanied with regulatory andsupervisory factors. Hence, the significance of regulatory and supervisory frameworkof the banking system is once more justified.

Keywords: Banking Regulation and Supervision, Banking Crisis.

JEL Classification: G18, G21, G28

Özet - Bankac›l›k Sektörü Düzenlemesi ve Denetlemesi ile Bankac›l›k Krizleri: Ülke Baz›nda Ampirik S›nama

Bu çal›flman›n temel amac› bankac›l›k sektörünün düzenlenmesi ve denetlenme-sindeki zay›fl›klar ile bankac›l›k krizleri aras›nda net bir iliflki olup olmad›¤›n› ampirikolarak s›namakt›r. Ampirik bulgulara göre sermaye düzenlemeleri krizlerin önlenme-sinde önemli bir unsur olup, sermaye yeterliliklerinin yükseltilmesine yönelik önerile-ri destekler niteliktedir. Di¤er taraftan, daha s›k› sermaye düzenlemeleri mevduat gü-vencesi taraf›ndan oluflturulan “ahlaki çöküntü” probleminin olumsuz etkisini azalta-cak nitelikte de¤ildir. Enflasyon, krizlerin ç›kmas›nda önemli rolü olan bir de¤iflkeniken, düzenleme ve denetlemeye iliflkin baflka de¤iflkenlerle birlikte test edildi¤indeönemi azalmaktad›r. Bu durum, bankac›l›k sektörünün düzenlemesi ve denetlemesi-nin önemini bir kez daha desteklemektedir.

Anahtar Kelimeler: Bankac›l›k Sektörünün Düzenlemesi ve Denetlenmesi, Bankac›l›k Krizi.JEL S›n›flamas›: G18, G21, G28

* Expert, Central Bank of the Republic of TurkeyThe views expressed in this paper are solely of the author, and do not necessarily reflect the viewsof the Central Bank of the Republic of Turkey

11

1. Introduction

Weakness of the regulation and supervision of the financial system is viewed as

a major factor, contributing to the emergence of bank failures (Fischer and Reisen,

1992:103; Noy, 2004:341; Mishkin, 2001:8) and financial crisis. It is argued that if

financial liberalization is accompanied with weak prudential supervision of the ban-

king sector, then it will result in excessive risk taking by financial intermediaries and

a subsequent crisis (Demirgüç-Kunt and Detradiache, 1998; Edwards, 2000; Rossi,

1999; Mehrez and Kaufmann, 2000).

Analogous to these arguments, weak regulation and supervision has been held

at least partly responsible for leading to crises in countries ranging from the United

States and Japan, to Korea and Mexico, Chile, Thailand on the one hand, to India,

Russia, Ghana and Hungary, on the other (Barth et al., 1999a:1). The most striking

and strong arguments in this context have been raised for the Asian crisis. It is as-

serted that it would have been possible to avoid the Asian crisis, if banks had been

supervised well (Williamson, 1999:10; Intal et al. 2001:43). Mishkin (2001:8) provi-

des support for this thesis by arguing that the non-crisis countries in East Asia, which

are Singapore, Hong Kong and Taiwan, had very strong prudential supervision. Cor-

bett, Irwin and Vines (1999:193) claim that vulnerability to crisis in Asia was crea-

ted by “liberalization of both trade and financial markets in the presence of an un-

reformed financial system”(1). Then, more recently, economic crises experienced by

Turkey in 2000 and 2001 have drawn attention to the strong correspondence bet-

ween weak regulation and supervision of the banking system and the outbreak of

crises. In the case of Turkey, it is argued that weaknesses in the regulation of both

public and private banks contributed significantly to the emergence of crises(2).

Furthermore, a cross-country comparison(3) conducted by Williamson and Mahar

(1998) concludes that prudential regulation and supervision was stronger in coun-

tries experiencing less severe financial crisis as compared to those experiencing a

12 Aytül Ganio¤lu

(1) “The key mistake, which led to the vulnerability of the financial system in Asia, is believed to bethat the old-style financial system continued into the new era of liberalization” (Corbett, Irwin andVines, 1999:194).

(2) Alper and Önifl (2002:2) argue that private commercial banks were instrumental in the outbreakof November 2000 crisis, while it was public banks that were the chief culprits in the subsequentcrisis of February 2001.

(3) They constructed an index of the level of prudential regulation and supervision in thirty-three co-untries. Average level of prudential regulation and supervision in all the countries that experien-ces financial crises is examined regardless of whether the crisis occurred before or after liberaliza-tion.

more severe crisis. Besides, average level of prudential regulation and supervision in

the five-year period preceding a crisis is found not to be independent from the oc-

currence of a banking crisis.

While weakness of the banking sector, of course, is not the only element that

generates vulnerability to economic crisis, banking regulation and supervision emer-

ges as a major component of vulnerability to crisis. It is argued that as capital acco-

unt liberalization intensifies capital mobility, this imposes a greater burden on a co-

untry to assure that its financial system is well supervised and regulated (Dornbusch,

1998:20). It is asserted that strong banking systems can better handle reversals in

capital flows, while weak and inefficient banking systems are less able to cope with

volatile capital flows, therefore, are more vulnerable to contagion (Johnston,

1998:5; Johnston et al., 1997:7). This means that they are more likely to propaga-

te and magnify the effects of financial crises on other economies. Furthermore, it is

claimed that concerns about banking solvency or inadequate regulatory frameworks

may encourage capital flight.

While an extensive literature is devoted to explain reasons and consequences of

financial, mostly banking, crises, reforms proposed to help preventing crises mostly

include changes in existing financial regulations and supervisory standards. There

exists a long list of “best practices” for the regulation and supervision of banks,

which is proposed by the Bank for International Settlements (BIS) and further exten-

ded by the IMF and the World Bank. The underlying phenomenon is the belief that

if only policymakers in countries around the world would implement particular re-

gulatory and supervisory practices, then banks would be sound and strong, which

would prevent banking crises to great extent.

Hence, almost all international financial institutions, but especially the World

Bank and the IMF have begun to urge countries to adopt and implement approp-

riate regulations and supervisory practices for their financial systems. For instance,

Barth et al. (1999b:1) emphasize that the World Bank stresses the importance of

prudential regulation and supervision more than ever in its all financial sector revi-

ews and projects. It is believed that improvements in the existing financial systems

will reduce the likelihood of financial instability and crisis(4).

The validity of these assertions and beliefs should be questioned, as there is re-

latively very little empirical evidence that supports the advice for regulatory and su-

pervisory reforms. For instance, there exist only a few studies that question whet-

her the so-called “best practices” currently being advocated by international agenci-

13Prudential Regulation and Supervision of the Banking Sector and Banking Crises:

A Cross Country Empiricial Investigation

(4) See Neyapt› and Dinçer (2005b) for a discussion about the hypothesis that experience of financialcrises results in the lesson of adopting higher quality of regulatory and supervisory environment.

es are the best ones for promoting well-functioning banks and whether successful

practices in the United States succeed in countries with different institutional and

political environments (Barth et al., 2002:1).

The reason for the absence of adequate empirical evidence in the literature is the

lack of detailed cross-country comparisons of financial and regulatory systems for

developing countries and the difficulty of obtaining adequate measures to describe

the regulatory and supervisory structure. It was only very recently, in 1999, that da-

ta on the practices of various financial regulatory and supervisory authorities for a

wide range of countries began to be assembled and analyzed. Hence, the push to

reforming financial regulation and supervision by international institutions has be-

gun without even the knowledge as to whether or under what circumstances the-

se efforts will be successful (Barth et al., 1999a:3). Furthermore, advice for banking

reforms to prevent banking crises began without sufficient information about the

extent to which these regulatory and supervisory reforms increase or decrease the

likelihood of a banking crisis. In addition, there is very little knowledge about the ap-

propriate way to reform financial sector regulation and supervision in many countri-

es. In view of the fact that capital requirements and regulatory standards recom-

mended by the Basel Committee are designed for industrial countries, their approp-

riateness for emerging market countries have been rightly questioned in recent ye-

ars especially in the face of severe banking crises(5).

There exist mainly two approaches to measure the quality of banking regulation

and supervision: 1) evaluation of the letter of the law and 2) surveys(6). Among the

survey-based approach to collect information related to bank regulations and super-

visory activities, the first extensive effort on a worldwide scale has been designed

and implemented by Barth et al. in 1999, through a questionnaire sent to more than

107 countries(7). Then, they used this data to assess the relationship between spe-

14 Aytül Ganio¤lu

(5) This argument is mainly raised and discussed by Rojas Suarez (2001).(6) Neyapt› and Dincer (2005a) discuss the advantages and disadvantages of both approaches. (7) This survey was funded by the World Bank. The data were based upon surveys sent to national

bank regulatory and supervisory authorities: The contact individuals at national regulatory and su-pervisory agencies were provided by the Basel Committee on Banking Supervision. Furthermore,participants to the World Bank seminars for bank supervision from emerging market countries we-re also asked to complete the survey. Furthermore, the World Bank personnel traveling to coun-tries that had not yet responded to the survey delivered the survey to the appropriate officials.The data is available at the following website:http://www.worldbank.org/research/projects/bank_regulation.htm.http://econ.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTRESEARCH/0,,contentMDK:20345037~pagePK:64214825~piPK:64214943~theSitePK:469382,00.html

cific regulatory and supervisory practices and banking sector development and fra-

gility in a series of studies (Barth et al., 1999a; 1999b; 2002). Previously, again thro-

ugh a survey based approach, information was collected by Claessens (1996) for a

rather limited group of countries, twenty-five transition countries and six compara-

tor countries. The alternative approach, that is, measurement based on various le-

gal attributes, has been carried out by Dincer and Neyapti (2005) to evaluate the

quality of the legal aspects of bank regulation and supervision for twenty-three tran-

sition countries.

Our purpose in this study, first of all, is to see whether there really exists a clear

association between weaknesses in the regulation and supervision of the banking

sector and financial crises through an empirical analysis. We specifically ask the fol-

lowing questions: Is the weak banking sector supervision and regulation a major

contributor to banking crisis? What is the relative role of macroeconomic deteriora-

tion in the generation of the crisis, especially when examined together with variab-

les related to the supervisory and regulatory framework.

Our analysis differs from that of Barth(8) et al. (2002) in that we incorporate va-

rious macroeconomic indicators into the analysis. Empirical results in this study po-

int to the robust significance of deposit insurance and capital requirements in lea-

ding to crises. Our test results indicate that capital regulations is a major factor in

the prevention of crises, which give important support to the propositions led by in-

ternational agencies towards ensuring higher capital requirements. On the other

hand, tighter capital regulations do not seem to mitigate the negative impact of mo-

ral hazard problem generated by generous deposit insurance system, which is a stri-

king message against propositions raised by international financial institutions to-

wards stressing more stringent capital requirements as a remedy for generous de-

posit insurance system. While inflation is a major macroeconomic indicator, with a

significant role in the generation of crisis, its significance weakens to a major extent,

when accompanied with regulatory and supervisory factors. Hence, the significance

of regulatory and supervisory framework of the banking system is once more justi-

fied.

This paper is organized as follows: The reasons for the need for a strong regula-

tory and supervisory framework of the banking system are explored in section 2.



(8) Inflation was the only macroeconomic indicator they have used in their banking crises regressions.

Section 3 discusses previous studies. Section 4 is devoted to our empirical analysis.

Section 5 concludes.

2. Excessive Risk Taking by Banks and the Need for PrudentialRegulation and Supervision

Banks generally have an incentive to engage in excessive risk-taking and specu-

lative activities as long as they guarantee that their failure will not threaten their sha-

reholders and managers. This guarantee is provided by deposit insurance, implicit or

explicit guarantees for bail-out by the government and through easy access to the

lender-of-last resort facility (Akyüz, 1993:16).

Deposit insurance, which is a scheme particularly observed in developing countri-

es and designed to protect depositors and attract funds to the banks, provides a

kind of guarantee that financial institutions would not be allowed to go broke

and/or government bail-outs would protect them. Then, banks having this guaran-

tee, being obliged to pay very little for the insurance coverage, may have all the in-

centives to channel funds into high-return, high-risk and speculative projects and be

illiquid (Akyüz, 1993:16). These incentives provided by deposit insurance system sti-

mulate excessive risk-taking by banks in the presence of weak prudential regulation

and poor supervision, either in design or enforcement or both, such that the levels

of bank capital and provisions for loan losses become inadequate. McKinnon

(1998:56) calls this situation as the “overborrowing syndrome”, which refers to ex-

cessive bank lending.

The threat for the economy emerges when banks expand their risky activities at

rates that far exceed their capacity to manage them prudently. For instance, the ma-

in reason behind the collapse of the domestic financial system in Latin America in

the early 1980s was the belief among depositors and financial intermediaries that

the government would step in crisis times to protect depositors’ savings and prevent

closure of financial firms. Even if there was no explicitly stated guarantee by the go-

vernment, the fact that there was no credible threat of bankruptcy and a belief of

full guarantee among domestic depositors and foreign lenders resulted in moral ha-

zard problems. These problems were further aggravated by inadequate supervisory

and prudential regulation system.

According to Corbett et al. (1999:209), the Asian crisis was the “consequence of

insufficient institutional development in the region during the miracle boom peri-

od”. It is argued that implicit guarantees in the financial system were one of the ma-

16 Aytül Ganio¤lu

jor flaws during the period of liberalization. Therefore, one of the factors that crea-

ted vulnerability in Asia was the presence of a bank-based financial regime in which

“there was implicit promises of a government bailout of the financial system in the

event of bad out-turns” (Corbett et al., 1999: 191).

Consequently, strengthening prudential regulation and supervision is necessary

to deal effectively with the banking sector risks, particularly in the context of capi-

tal account liberalization. Moreover, strong regulatory and supervisory policies are

important to minimize moral hazard (including corruption, fraud and excessive risk

taking) in the banking system. Moreover, the existence of systemic risk provides

strong arguments for regulation(9). Since each bank is an integral part of the pay-

ment system, failure of a bank can generate a domino effect on the other solvent

and profitable banks. Therefore, risk of a system failure forms the basis of the argu-

ment of insuring banks against liquidity shocks. The Asian crisis of 1997 is an examp-

le for the problem of systemic risk. Another reason for bank regulation is the exis-

tence of asymmetric information problem and the inability of small depositors to

monitor banks. Concerning the inability of small depositors to monitor banks, it is

argued that there is a need for the regulatory authority agent to act as a public rep-

resentative of depositors (Alper and Önifl, 2002:5-6).

Alper and Önifl (2002:5) assert that effective regulation is particularly important

for what they call “transitional financial systems” to describe a system where mar-

ket liberalization proceeds rapidly in the absence of an effective legal and institutio-

nal infrastructure. These intermediate regimes are observed in emerging market

economies such as Turkey, Mexico and Argentina. It is argued that there is a clear

need to develop a strong banking regulatory framework for such transitional finan-

cial systems in terms of both preventing crises and achieving long-term economic

growth.

Ultimate objective of prudential regulation and supervision of the banking sector

is, therefore, stabilizing the financial system and obtaining public confidence in its

stability, as well as being able to manage systemic risk and protect clients. Hence,

supervision and prudential standards should be improved so as to ensure that banks

meet capital requirements, make adequate provision for bad loans, limit connected

lending, and publish informative financial information, and that insolvent instituti-

ons are dealt with rapidly (Fischer, 1998:4; Mathieson and Rojas-Suarez, 1994:343).



(9) See Alper and Önifl (2002) and Santos (2000:5-6) for a detailed discussion.

3. Previous Studies

The question that we aim to answer in this study, i.e. the issue whether the we-

ak banking sector regulation and supervision is closely associated with financial cri-

sis, has been explored empirically in a few studies.

Demirgüç-Kunt and Detragiache (2000) found that presence of an explicit depo-

sit insurance scheme tends to increase the probability of systemic banking problems.

For the period (1981-1997) that they examined, they have concluded that moral ha-

zard played a significant role in leading to systemic banking problems, especially sin-

ce countries with deposit insurance schemes did not control successfully the nega-

tive effects of moral hazard through appropriate prudential regulation and supervi-

sion.

One of the studies that examine the links between capital account liberalization,

prudential regulation and supervision and financial crises is an IMF Working Paper

by Rossi (1999). The difficulty of comparing regulatory practices for a range of co-

unties is overcomed in this study through developing an index that accounts for dif-

ferences of the regulatory and supervisory practices of different countries in terms

of internationally accepted guidelines. One of the results of the study is that lax pru-

dential practices and higher depositors’ safety seem to exacerbate financial fragility.

Rossi (1999:15) concludes that banking crises are more likely in the presence of con-

trols on outflows, of laxer prudential regulation and high depositors’ safety. The stri-

king conclusion of this paper is that capital account liberalization is found not to ha-

ve contributed to the banking crises, as one would expect from a study carried out

by an IMF staff member. Furthermore, a less repressed financial system is found to

allow countries to achieve financial stability and higher economic activity over the

business cycle.

Noy (2004) searches for empirical evidence to the hypothesis that if liberalizati-

on is accompanied by insufficient prudential supervision of the banking sector, then

it will result in financial crisis. He concludes that insufficiency of the prudential regu-

lation and supervision presents only a medium term threat to the banking sector.

However, he complains about the weaknesses of supervision variables he used in

regressions. Furthermore, he (2004:356) adds that “the onset of banking crisis is a

process that embodies a lot of institutional and political details that have been, un-

til now, beyond the reach of econometric research”. On the other side, he found al-

most all macroeconomic and financial variables he included –inflation, M2/reserves

ratio, GDP growth rate, real exchange rate and foreign interest rates- as significant

contributors to the likelihood of a banking crisis.

18 Aytül Ganio¤lu

Barth et al. (1999b) questioned whether countries with more restrictive regula-

tory systems have a lower probability of suffering a banking crisis. They (1999b:12)

found that restricting bank activities tends to increase the likelihood of suffering a

major crisis. Particularly, in countries in which securities activities are restricted, the

likelihood of a banking crisis is greater. This finding is quite opposite to those, which

claim that stricter restrictions on the allowable activities of banks constraints exces-

sive risk taking behavior. Furthermore, Barth et al. (2002:15) found no evidence for

the proposition that strict capital adequacy regulations ameliorate the risk taking in-

centives produced by generous deposit insurance. They (2002:15) argue that while

these results do not imply that capital is unimportant for bank fragility, “they sug-

gest that there is not a strong relationship between the stringency of official capi-

tal requirements and the likelihood of a crisis after controlling for other features of

the regulator and supervisory regime”. Furthermore, they accept that “this finding

contradicts conventional wisdom and the current focus of the policy advice being

advanced by international agencies” (Barth et al., 2002:15).

4. Empirical Analysis

4.1. Data

In this study, the main challenge of finding regulatory and supervisory data on

cross country basis has been recovered by using the database that is compiled by

Barth, Caprio and Levine by conducting a survey(10) on the different financial regu-

latory and supervisory environments that exist in 107 countries throughout the

world. These survey results give information about the extent to which various re-

gulatory and supervisory practices in different countries accommodate international

best practices.

The regulatory and supervisory data are measured over the 1998-2000 peri-

od(11). Since most of the crises occurred throughout the 1990s and a time-series da-

tabase on the full range of bank regulatory and supervisory policies is not available,

a careful examination of the regression results is needed. Due to unavailability of a

time series database on the range of bank regulatory and supervisory data used in

this paper, the study by Barth et al.(2001) which showed that restrictions on bank



(10) Barth, Caprio and Levine designed and implemented a survey funded by the World Bank to col-lect information on bank regulations and supervisory practices.

(11) Barth et al. (2002:16) mentions that of the 107 responses received, 13 responses were receivedin November 1998, 65 were received in 1999, and 29 in early 2000. Data is available at the follo-wing website: www.worldbank.org/research/interest/intrstweb.htm

activities have not changed much over the last two decades removes the doubt to

some extent.

Furthermore, it should be reminded that since surveys focus on practice, subjec-

tive judgments of evaluators might undermine the quality of data. On the other

hand, the alternative method of measurement of bank regulatory and supervisory

framework based on evaluation of the letter of law(12) has the disadvantage of not

reflecting practice, while minimizing the subjective evaluations. Hence, being awa-

re of the fact that both surveys and evaluation of legal attributes have their own ad-

vantages and disadvantages, we choose to use survey results(13), leaving the analy-

sis based on legal attributes and comparison of the two methodologies to another

study.

Indices used in the empirical analysis were provided by Barth, Caprio and Levine

on our request. Basically, these aggregate indices are obtained by incorporating the

answers to many questions(14). Table 1 provides information about all variables by

name, definition, sources and the time period that the data covered. The entire da-

tabase embraces 4 qualitative and 7 quantitative variables. Qualitative variables are

systemic banking crises, capital regulatory index, restrictions on bank activities and

moral hazard index and. Quantitative variables are bank development data as well

as control variables(15), which are inflation, current account balance as a percenta-

ge of GDP, GDP per capita growth, real interest rate, domestic credit provided by

banking sector as a percentage of GDP, gross private capital flows as a percentage

of GDP as the macroeconomic factors likely to lead to a crisis.

The sample covers both developing and developed countries. The 40 countries

included in the sample are as follows: Developing countries are Argentine, Brazil,

Chile, China, Czech Republic, Greece, Hungary, Indonesia, India, Korea, Malaysia,

Mexico, Philippines, Poland, Portugal, Romania, Russia, Singapore, Thailand, Turkey

and Venezuela. Developed countries are Austria, Australia, Belgium, Canada, Den-

mark, France, Finland, Germany, Ireland, Israel, Italy, Japan, Spain, Switzerland,

Sweden, Netherlands, New Zealand, United Kingdom and United States.

20 Aytül Ganio¤lu

(12) Neyapt› and Dincer (2005a) use the database based on evaluations of legal attributes of bankingregulation and supervision.

(13) For more information about advantages and disadvantages of both approaches, see Neyapt› andDincer (2005a)

(14) For more information about specific survey questions used to construct indices, see Barth et al.(2002:21)

(15) Debt/GDP ratio and exchange rate regime can also be considered as control variables, which isplanned to be included in another study.

Table 1: Data Base



4.2. Descriptive Statistics and Regression Results

The relationship between banking crises and regulatory and supervisory environ-

ment are examined using both simple correlations and logit regressions. We first

present the simple correlations between the three measures of the regulatory envi-

ronment(16) -capital regulatory index, moral hazard index and restrictions on bank

activities index-, which are found to be significant in the empirical analysis, and ban-

king crises. Then, regression results are presented, where we control for inflation

and current account balance to GDP ratio. Although all quantitative variables are in-

volved in these regressions, only the results related to inflation and current account

balance to GDP ratio will be reported. This arises from the fact that other quantita-

tive variables have been found insignificant. It is important to control for these vari-

ables, i.e., macroeconomic indicators in evaluating the relationship between the re-

gulatory/supervisory environment and banking crises.

4.2.1. Correlations

In this section, only the variables, which are found to be significant in the empi-

rical analysis, are involved in the analysis for correlations among variables. On the

basis of correlations between banking crisis and regulatory environment as well as

macroeconomic indicators, we found positive correlation between banking sector

crisis and generosity of the deposit insurance regime (high values of the Moral Ha-

zard Index), inflation as well as regulatory restrictions on bank activities (see Table

A.1 in the Appendix). In other words, increases in the rate of inflation, more gene-

rous deposit guarantee and restrictions on bank activities raise the likelihood of suf-

fering a banking crisis. There is a negative correlation between banking sector crisis

and capital regulatory index and current account balance to GDP ratio. Signs of the-

se correlations are as expected. Signs of all correlation coefficients are as expected.

4.2.2. Estimation Methodology and Regression Results

In the empirical analysis, the dependent variable is a dummy variable called CRI-

SIS, where CRISIS equals 1 if a country suffered a banking crisis and CRISIS equals

0 otherwise. A country is considered to have a crisis if the estimated losses to the

government due to bank failures are greater than five percent of GDP (Barth et al.,

1999b:14).

22 Aytül Ganio¤lu

(16) There exist many variables provided by Barth et al. related to regulatory environment and they areinvolved in the estimation regressions, but only these three regulatory variables have been foundsignificant in these estimations. Hence, only those variables are reported in the data set and reg-ression results.

Table 2: Banking Crises Regressions

Table 2 presents logit regressions on the relationship between the likelihood ofexperiencing a banking crisis and each bank regulation and supervision indicator(17),while controlling for macroeconomic instability indicators such as inflation and cur-rent account balance to GDP ratio, which are generally accepted as important de-terminants of banking crises.

The overall empirical test results based on logit regressions state that moral ha-zard and the capital regulations emerge as the most important variables that affectthe probability of a banking crisis. The results suggest that there is a robust relati-onship between capital regulations, i.e. stringency of official capital requirementsand the likelihood of a banking crisis after controlling for other characteristics of theregulatory and supervisory environment and macroeconomic instability indicators(equations 2, 5, 6)(18). This finding is contrary to the one reached by Barth et al.(2002:33). On the other hand, this result is quite consistent with the current policyadvices of the international institutions.



(17) Neyapt› and Dinçer (2005b) show that prevailing financial crises positively affect bank regulationand supervision and hence, its quality may increase with the lessons derived from crises.

(18) Capital requirements are expected to provide a buffer against unexpected losses for ensuring safety andsoundness of the banking system. That is to say, accumulation of capital in banks’ balance sheets is expect-ed to act as buffer against adverse shocks they face in order to minimize the likelihood of severe financialdisturbances. As capital absorbs possible losses, it is the ultimate determinant of a banks’ lending capaci-ty. It is asserted that even in the absence of deposit insurance, capital requirements are needed to mini-mize the outbreak of a systemic banking crisis (Rojas-Suarez, 2001:3). It is argued that requirement of suf-ficient capital not only helps to minimize the occurrence of crisis, but minimizes the total social cost of cri-sis resolution if a crisis occurs. Therefore, capital requirements are not just linked to individual bank’s assetsbut also to the risk of systemic failures. The Basle I Accord published in 1988 by the Basel Committee onBanking Supervision has been the central guide for regulating bank capital requirements.

Results also support the association established in the literature between the ge-

nerosity of the deposit insurance system and the likelihood of a banking crisis(19).

This positive relationship is quite robust to alterations in the control variables(20).

Furthermore, tighter capital regulations do not seem to mitigate the negative im-

pact of moral hazard problem generated by generous deposit insurance system,

which is a striking message against propositions raised by international financial ins-

titutions towards stressing more stringent capital requirements as a remedy to ge-

nerous deposit insurance system. Hence, while an increase in the moral hazard in-

creases the probability of a banking crisis, an increase in the capital regulatory index

decreases the probability of such a crisis.

A third seemingly important variable is the restrictions on bank activity. When we

control for macroeconomic indicators (equation 4), countries with more restrictions

on bank activities have significantly high probabilities of suffering a banking crisis.

Positive link between the likelihood of a crisis and greater restrictions on bank acti-

vities are explained by Barth et al. (2002:31) by arguing that diversification of inco-

me sources through nontraditional bank activities –allowing banks to engage in an

assortment of activities- tends to be positively associated with bank stability, especi-

ally in economies with active non-bank financial markets.

Most importantly, the regression results suggest that the macroeconomic dyna-

mics such as inflation and the current account deficit, turn out to be insignificant

when the structural variables are added to the regressor set. When these structural

variables such as the moral hazard index and capital regulatory index are accounted

for, the impact of these macroeconomic variables become negligible.

5. Conclusion

If financial liberalization is undertaken in the presence of weak prudential regu-

lation and supervision of the banking sector, financial liberalization motivates and

enables excessive risk taking by financial institutions and creates distortions in the

allocation of credit. It further increases the vulnerability of banks to shocks and sub-

sequent crisis. On the other hand, presence of efficient supervision and regulation

is viewed as a guarantee that prevents excessive risk taking, hence, it is argued that

financial liberalization is unlikely to have adverse effect on the stability of the ban-

king sector.

24 Aytül Ganio¤lu

(19) Demirgüç-Kunt and Detragiache (2000) reached the conclusion that deposit insurance generositypredicts future banking crises. Barth et al. (2002:34) also find a strong relationship between thesetwo variables.

(20) For instance, in regressions involving the variables of GDP per capita growth, real interest rate,domestic credit provided by the banking sector as a percentage of GDP.

Inherent micro-economic imperfections facing the banking industry such as ad-

verse selection, moral hazard, principal-agent issues and other micro-imperfections

due to informational asymmetries and uncertainties lay the basis of the difficulties

of designing appropriate framework for banking sector regulations and of preven-

ting excessive risk taking activity by banking sector. Excessive risk taking, in turn, re-

sults in deterioration of financial sector balance sheets, which can, by itself, be suf-

ficient to lead to financial or economic crises. Thus, it seems that regulatory impro-

vements should discourage excessive risk-taking by financial institutions.

The issue of the appropriateness of proposed regulations for developing countri-

es is not considered in the present study. Instead, we consider the role of regula-

tory and supervisory framework in the context of banking crises. In particular, we

ask whether weak regulatory and supervisory framework is sufficient for creating a

suitable environment for banking crisis. Empirical results point to the robust signifi-

cance of deposit insurance and capital requirements in leading to crises. While mo-

ral hazard arising from deposit insurance was found as a major factor in leading to

crises before by other studies, capital regulatory index was found insignificant by

Barth et al.(2002). Our test results indicate that capital regulations is a major factor

in the prevention of crises, which give important support to the propositions led by

international agencies towards ensuring higher capital requirements. On the other

hand, tighter capital regulations do not seem to mitigate the negative impact of mo-

ral hazard problem generated by generous deposit insurance system, which is a stri-

king message against propositions raised by international financial institutions to-

wards stressing more stringent capital requirements as a remedy for generous de-

posit insurance system.

While inflation is a major macroeconomic indicator, with a significant role in the

generation of crisis, its significance weakens to a major extent, when accompanied

with regulatory and supervisory factors. Hence, the significance of regulatory and

supervisory framework of the banking system is once more justified.

As suggested by the empirical findings in this study that the nature of the ban-

king crises is closely associated with the institutional structure of the financial sys-

tem rather than macroeconomic conditions of the economy. It can be concluded

that once a solid institutional structure of the banking system is established, worse-

ning macroeconomic conditions need not lead to a banking crisis. Thus, in order to

prevent banking crises, the policymakers should focus more on the institutional fac-

tors, such as moral hazard problem, capital regulations and restrictions on bank ac-



tivities. On the other hand, if these conditions are not met, then worsening macro-

economic conditions most probably lead to a banking crisis.

While this conclusion supports the view that weakness of the banking system has

played a major role in leading to 2000 and 2001 crises in Turkey, the issue that

whether it would have been possible to prevent crises in Turkey through proper imp-

lementation of prudential banking regulation and supervision can be a research qu-

estion of another study.

26 Aytül Ganio¤lu

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APPENDIX

Table A.1: Correlations Among Selected Variables

prudential regulation and supervision of the banking ...€¦ · prudential regulation and...

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